Stock Analysis: Forecasting Revenue and Growth

Financial modeling is a key component of stock valuation, and essential to stock valuation is forecasting a company’s growth and revenues to estimate its expected earnings over specific periods.

Estimated earnings are then used to estimate growth, which helps analysts value a stock, decide whether it is over- or undervalued, estimate profit potential, and assign it a multiple—factors critical to stock selection.

Key Takeaways

• There are many factors to consider when forecasting revenue, such as pending news or product and service releases, economic indicators and conditions, consumer behavior, industry outlooks, and more.
• Forecasting growth requires estimates of product prices and future unit sales.
• Estimated revenues and growth are used to assign multiples and valuate stocks.

Forecasting Revenue

Analysts begin forecasting revenue by gathering financial data from a company, its industry, consumer behaviors, and economic and competitive conditions. Any publicized company events, such as the pending release of a new product or a merger or acquisition, are factored into the analysis.

Typically, both companies and industry trade groups publish data related to the potential size of the market, the number of competitors, and current market shares. This information can be found in annual reports and through industry groups. Consumer data ascertained from buyer surveys, UPC bar coding, and similar outlets paint a picture of current and future expected demand. 

Further inputs are needed to specifically model a company’s revenue forecasts. Financial statements, such as the balance sheet, inform analysts of a company’s assets and debts and any changes from one period to another. Often, companies provide updates on inventory, shipments, and expected unit sales in the current period.

Pricing Data

Average price-per-unit can be calculated using the revenue provided in the income statement divided by the change in inventory (or number of units sold). For past transactions, these data can be found in Securities and Exchange Commission (SEC) reports, but for future transactions, assumptions are required—like the impact of competition on pricing power and expected demand versus supply.

In competitive markets, prices usually fall, either directly through price cuts or indirectly in the form of rebates. Competition comes in the form of similar products by different manufacturers, or new products entering and cannibalizing old ones. When supply exceeds demand, companies usually push products to the consumer, typically resulting in lower price points.

Calculating Forecast Revenue

Forecasted revenue is usually calculated by multiplying the average selling price (ASP) for future periods by the number of expected units sold. These calculated forecasts can be “confirmed” by company management, who may discuss revenue and its expectations for growth on conference calls, usually scheduled around the release of the latest annual or quarterly report. Additionally, company management may participate in intra-period events, such as industry conferences, where they release new information on inventory, market competitiveness, or pricing to confirm or assist in building revenue models.

Forecasting Growth

Once revenue is determined, future growth can be modeled. Applying a growth rate on revenue can help determine the future earnings growth. Setting the appropriate growth rate will be based on expectations about product price and future unit sales. Penetration into new and existing markets and the ability to steal market share will impact future unit sales. Industry outlook, analyzing the key product features, and demand are integral components to forecasting growth rates.

Let’s look at an example. Assume company ABC starts with $100 in revenue. It is expected to grow in-line with the market. ABC is forecasting its ability to increase market share and set prices. Here is its forecast:

Growth Rate Calculation

The following table estimates the growth rate using:

• Market growth: An estimate of the market’s growth rate
• Incremental market share gains: An estimate of the increases in market share over a period
• Pricing power: An estimate of a company’s ability to raise prices without decreasing demand

In Years 3 and 4, both incremental market share and pricing power decrease, which directly impacts growth rates. 

Impact of Forecasts on Valuation

Analysts’ ultimate goal when forecasting revenue and growth is to determine the appropriate value for a stock. After modeling expected revenue and concluding that costs will be close to the same fixed percentage of revenues, analysts can calculate expected earnings for each future period.

The following table shows the expected earnings for Company ABC:

From these models, analysts can then compare earnings growth to revenue growth to see how well the company is able to manage costs and bring revenue growth to the bottom line. 

In Years 1, 2, and 3, ABC’s expected earnings growth exceeds its revenue growth. The change in growth rates will be reflected in the valuation multiple the market is willing to pay for this stock. Stocks with sustainable or increasing growth rates will be assigned higher multiples, and stocks with no or negative growth will receive lower multiples. For ABC, increased growth from Year 1 to Year 2 will result in a high multiple, while the low growth in Year 5 (actually negative earnings growth compared to revenue growth) will be reflected in a lower multiple.

What Are the 4 Factors to Consider in Forecasting Revenues?

There are many factors to consider, including expected customer behaviors (demand), economic conditions, and the competitive environment in which the company operates.

What Is the Formula for Forecasting Revenues?

Generally, you multiply the average selling price (ASP) for future periods by the number of units a company expects to sell. There are many factors to consider when forecasting a company’s revenues, so revenue forecasts must be tailored to the company you’re evaluating.

What Is the Formula for Revenue Growth?

To calculate revenue growth, subtract the previous period’s revenue from the current period’s. Next, divide that result by the previous period’s revenue and multiply by 100.

The Bottom Line

Analysts’ forecasts are crucial to setting expected stock prices, which, in turn, lead to recommendations. Without the ability to make accurate forecasts, the determination to buy or sell a stock cannot be made. Although stock forecasts require the compilation of many quantitative data points from a variety of sources, as well as subjective determinations, analysts should be able to create a fairly accurate model to make recommendations.